Gavekal Capital: When $75 Billion In Intangible Capital Goes Unnoticed

Thursday, March 5, 2015

When $75 Billion In Intangible Capital Goes Unnoticed

One of the flagship principles of our investment process is an investment in intangible capital should be treated the same from an accounting standpoint as an investment in physical capital . Said differently, we are firm believers in the symmetry principle for capital accounting. In order to properly treat intangible investments according to the symmetry principle, one needs to capitalize R&D (and other intangibles) and create a long-term asset on the balance sheet. Once the asset has been created, it must be carried at historic, depreciated cost just as all tangible assets on a balance sheet are carried. By doing this, one gets a much fuller and richer view of the ENTIRE capital stock of a company. And as all investors know, a company's unique capital stock (or moat as Warren Buffet would call it) is what drives future profits. Thus, without having an understanding of just how big a company's capital base is, it is very difficult to forecast the amount of future profits that may be derived from that capital stock.

Let's take a real-life example from the systems software sub-industry to illustrate how much capital is currently going unnoticed by the financial community.

There are nine companies that make up the MSCI US systems software sub-industry. This sub-industry is made up of very well known companies such as Microsoft, Oracle, Symantec and VMWare.  It's a very profitable industry as the average gross margin is a very healthy 75% and three of these companies have managed to deliver gross margins above 80%. Oracle, Microsoft and Symantec have increased sales, EPS, BV per share, and cash flow per share by at least 15% a year for over two decades. It goes without saying that this is group of highly profitable, stable, long-term growth oriented companies.

It doesn't surprise us then to see that this group of companies are major investors in intangible investments.The average company in this sub-industry spends nearly 20% of its sales on R&D and another approximately 16% of its sales on other intangible investments. These intangible investments are not a one-off phenomena either. These companies invest large amounts into intangibles every single year in order to keep their respective competitive advantages. Over the past decade, this group of companies has invested about 20% of it sales into R&D and another 15% of its sales into other intangible investments. This means that over time these companies have built up a HUGE intangible capital stock that currently goes completely unaccounted for under traditional accounting practices. The question becomes, how big?


R&D Investment As A % Of Sales

Intangible Investment Ex-R&D As A % Of Sales

According to our work, the total capital stock of these nine companies is actually $75.5 billion more when intangible investments are properly accounted for. Or approximately 25% larger than is generally recognized. And remember, this is the depreciated, historic cost level of this asset. As a group, the "as-reported" level of their assets is $307 billion. Microsoft makes up over half of this as their "as-reported" asset level is $172 billion. If you include Oracle, then Microsoft and Oracle account for 85% of the "as-reported" assets in this sub-industry. When you look at it from intangible-adjusted perspective, the overall capital stock rises to $382 billion. Because Microsoft and Oracle are such consistent and persistent intangible investors, they continue to account for about 85% of the overall intangible-adjusted asset base of this industry.

As-Reported Balance Sheet Levels

Intangible-Adjusted Balance Sheet Levelsimage

For more information on intangible capital please see these other blog posts and videos.

Video - Why Knowledge Is Undervalued

Becton Dickinson Intangible Case Study

Emerging Market Intangibles

Video - How Intangibles Affects Intuit's Profitability Ratios

The Intangible Case For Autodesk

Why Intangibles Matter - An Amazon Case Study

Video - Gavekal Knowledge Leader Indexes